What are encumbrances in accounting, anyway?
In accounting, an encumbrance is a legal claim on company assets. This can be in the form of a lien, a mortgage, or any other type of security interest.
When an encumbrance is placed on company assets, it creates a financial obligation for the company that must be met before those assets can be used for other purposes.
But how are encumbrances in accounting different from other types of financial obligations?
Keep reading to learn what encumbrances are in accounting and how they compare.
What is an Encumbrance?
An encumbrance is a legal claim on company assets. This can be in the form of a lien, mortgage, or any other type of security interest.
When someone places an encumbrance on a company’s assets, it forms a financial obligation that the company must meet before using them for any other purposes.
This financial obligation can take many different forms, such as:
- A payment that must be made to the encumbrance holder to release the claim on the assets
- An ongoing percentage of revenue that must be paid to the encumbrance holder
- A requirement that the company must meet certain conditions before the encumbrance will be released.
For example, if a company has a mortgage on its property, the encumbrance holder (the bank) will have a legal claim on the property.
The company will be required to make regular payments to the bank in order to keep the property, and if it fails to do so, the bank can foreclose on the property.
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Encumbrance vs. Accounts Payable
Encumbrances differ from accounts payable in a few key ways.
First, encumbrances are always interest-bearing, whereas accounts payable are not.
Second, accounts payable generally have shorter terms than encumbrances.
And third, accounts payable are usually for specific goods or services that have been received, whereas encumbrances can be for future obligations.
Thus, encumbrances are more like long-term debt obligations, while accounts payable are more like short-term debts.
Pre-Encumbrance Accounting Explained
Pre-encumbrance accounting is the process of setting aside funds to cover future encumbrances.
This is typically done at the beginning of a fiscal year in order to make sure that there are enough funds available to cover all encumbrances that will come due during that year.
For instance, if a company has a mortgage on its property with a monthly payment of $1,000, it will need to set aside $12,000 in its pre-encumbrance account at the beginning of the year to cover these payments. If the company does not have enough funds available to cover all of its encumbrances, it may need to take out a loan or sell assets to raise the necessary funds.
The Importance of Pre-Encumbrance Accounting
Pre-encumbrance accounting is important because it helps companies to avoid defaulting on their financial obligations. If a company does not set aside enough money to cover its encumbrances, it may find itself in a difficult situation when the bills come due.
For example, if a company has a mortgage payment of $1,000 due at the beginning of the month but only has $500 in its pre-encumbrance account, it will need to find a way to come up with the other $500. This could mean taking out a loan, selling assets, or reducing expenses in other areas.
Pre-encumbrance accounting helps companies to plan for their future obligations and avoid defaulting on them. It is a critical part of financial planning and budgeting.
Encumbrance Accounting Example
Another example of an encumbrance is a contractual obligation.
If a company has signed a contract obligating it to purchase a certain amount of goods from another company, that company has an encumbrance on the first company’s assets.
The first company will be required to make payments to the second company in order to fulfill the contract.
If the first company does not have enough money to cover the contract, it may need to take out a loan or sell assets to raise the necessary funds.
Encumbrances can also be placed on a company’s assets by its creditors. For instance, if a company owes money to its suppliers, they may place an encumbrance on the company’s assets. This will give them a legal claim on the company’s assets and allow them to collect their debts if the company defaults.
Final Thoughts on Encumbrances in Accounting
Encumbrances are essential because they help companies to avoid defaulting on their financial obligations. By setting aside money to cover future encumbrances, companies can ensure they will have the funds necessary to pay their bills when they come due.
Pre-encumbrance accounting is also a critical part of financial planning and budgeting and should be done at the beginning of every fiscal year. Ultimately, encumbrances are an important part of accounting and financial planning, and companies should be aware of them when making their budget.